Among the many victims of the financial crisis are some of the most cherished and mostly deeply-entrenched beliefs about investing in general and investing in stocks in particular.
The foundation of all investment management for the last two generations is Modern Portfolio Theory, which posits diversification of assets among different investments classes, as a method of reducing risk and improving returns. Originally put forward in the 1950s, MPT was developed over the following half-century, with enormous efforts made to identify asset classes that were negatively correlated to each other – meaning that they didn’t move in the same direction over time. However, in the extreme conditions of September-November 2008, MPT underwent its supreme test – and was found wanting. When liquidity dried up and the entire financial system faced the mother of all margin calls, all previous relationships collapsed and the prices of virtually every investible asset slumped in unison.
A belief even more widely held was that, ‘in the long term’, equity investments generated higher returns than bonds. The long term was usually interpreted as 10 years, so that periods of recession could not distort the underlying trends. But the size of the bear market that began in October 2007 destroyed the basis for this belief, too. Coming on top of the 2000-2002 bear market – from which the Nasdaq market, for instance, never came near to recovering – the current bear has wiped out equity gains going back to the 1990s. Consequently, even an investment in short-term Treasury bills, let alone higher-yielding Treasury bonds, provided much higher returns from 1997 or 1998 through to the present.
This development, in turn, undermined two pillars of the investment strategies of both institutional investors, such as pension funds, and households. The first was that, since equities perform better over the long term, an investor with a long-term horizon who was prepared to ignore the ups and downs of the market along the way, ought to have a portfolio skewed towards equities. That’s why the typical American or British pension fund held upwards of 60% of its assets in equities, and only a minority in bonds. Households, too, concentrated on equity-oriented mutual funds. As a result, these investors suffered disproportionately in the crash, as equities were hammered whilst government bonds rose strongly.
The second pillar was a derivative of the first. Since equities were supposed to be the best long-term investment, the optimum strategy was to identify companies with a positive track record and good future prospects, buy their shares, and sit on them. Buy-and-hold was the mantra of American households, many of whom did their own equity research and knew a great deal about the companies they bought (or thought they did), whilst others put their money in mutual funds whose managers did much the same. After all, what was the point of buying and selling frequently, thereby incurring costs, if the long-term results of passive buy-and-hold would be more than satisfactory.
Both these pillars, equity-heavy portfolios and buy-and-hold strategies, buckled under the impact of the mega-bear of October 2007-March 2009. But having said that – now what? Clearly, for anyone who believes that we have seen the low, turned the corner and are on the bumpy road to recovery, equities should outperform bonds over the next 10-15 years – although whether buy-and-hold is, or ever was, a good strategy, is open to debate.
But if you accept, or even lean towards, the many analysts (overwhelmingly the independent ones, not those employed by big banks and investment houses) who are convinced that the current surge in share prices is a bear market rally, to be followed by another downswing that will, at the least, revisit the lows of early March, then you might consider the following: The old verities about investing are destroyed and many of the supposedly solid ‘blue chips’ have been exposed as hollow shams. The long-term superiority of equities is a myth and the short-term looks grim. The rally has provided an opportunity to sell out with much smaller losses than had seemed possible only a few weeks ago. Time to say bye-bye to buy-and-hold?